Smith Faculty Opinion Article

By Dr. John A. Haslem, Professor Emeritus of Finance E-MAIL WEB SITE

The 30 Seconds Outlook
November 15, 2009

A critical issue in this time of financial and economic crisis is whether tax cuts or increases in government spending are more likely to expand economic growth. This is a widely debated question to which Alesina and Ardagna provide important empirical findings across 20 ECU countries during the years 1970 to 2007.

“Our results suggest that tax cuts are more expansionary than spending increases in the case of a fiscal stimulus. . . . [W]e would argue that the current stimulus package is too much tilted in the direction of spending rather than tax cuts. For fiscal adjustments [deficit reductions] we show that spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns.” These results suggest that Obama’s fiscal stimulus has taken the wrong approach.

Simple regressions of changes in fiscal policy on GDP growth find that a one percentage point increase in spending is associated with a 0.75 percentage point decrease in growth. For economic growth, the composition of fiscal stimulus is more relevant. Both spending and tax increases can have negative associations with growth. The larger the share of spending in the decline in budget balance, the lower GDP growth. A one standard deviation increase in spending would reduce growth by one percentage point.

Fiscal stimuli based more heavily on increases in spending items are associated with lower GDP growth. And fiscal stimuli based on cuts in the various taxes are associated with higher growth.

Composition of fiscal adjustments matters for growth more than size of adjustment. Adjustments associated with higher GDP growth are those where the largest cuts in the deficit to GDP ratio are from spending cuts.

In summation, “. . . we find that larger reductions in current spending and in taxation are associated with higher GDP growth, while changes in capital spending do not show any significant effect on growth.”

The U.S. financial bailouts are responsible for a large portion of the huge government deficit now representing 12% of GDP. About two-thirds of the fiscal package represents increased spending, including public investment, transfer payments, and government consumption.

Fiscal stimuli based on tax cuts increase growth more than those based on additional spending. The stimulus plan is thus too focused on spending, except for increased unemployment benefits. Spending on infrastructure with such long lag times is very questionable. However, with U.S. families having a history of saving too little, they may have saved the tax cuts with little impact on increased total consumption spending. But, this saving could benefit the financial sector. However, investment could have benefited from tax cuts to business.

The resulting deficits are unlikely to be cleared up simply by rapid growth occurring very soon. Interest rates can only increase. Primary government spending needs to be tightly controlled or increasing taxes will not succeed in catching up to ever increasing deficits. High unemployment will require additional spending. Health care reform calls for large spending increases, and Social Security remains a problem. The CBO forecast deficits of 7% of GDP up to 2020---not a pretty picture for the country’s financial and economic wellbeing.

John A. Haslem